To LLC or Not To LLC
Choose wisely my founder friends
(First, a necessary disclaimer: this is not legal or tax advice. Seek out your own advisors, and don’t listen to some guy on the Internet.)
In a hurry? Scroll to The tld;r at the bottom.
In March 2010, I went to the Minnesota Secretary of State’s website and registered MobileRealtyApps.com, LLC as a Minnesota limited liability company. I made two mistakes that day. One I corrected and one I didn’t.
If I knew then what I know today, I would have registered a Delaware C corporation* at the start.
So, why did I choose a Minnesota LLC in the first place? Contrary to an oft-stated opinion, no one gave me bad legal advice. I chose this path myself. But it also wasn’t a decision made with complete naivety either. I had two prior life experiences that suggested this was absolutely the right path to take!
First, in 1997 my parents sold their manufacturing business of 15 years, and ultimately they regretted that they held a C corp. When they sold, their acquirer required that it be an ‘asset sale.’ In such scenarios, which are pretty standard in many corporate M&A transactions, an acquiring entity buys the assets from another entity. Still, it does not buy the actual corporation itself. There are several legal and accounting reasons that acquirers prefer this. As a result, my parents were hit with double taxation. The C corp. had to pay corporate taxes on the gain from selling its assets. Then when the company distributed the proceeds to my parents, they had to pay a dividend tax. Such double taxation seemed unreasonable to me. And I heard similar stories from other business owners in the years that followed, so this wasn’t an isolated instance.
Second, in 2004, we sold AltonaEd, LLC (a business I co-founded) to Pearson Education. It was also an asset sale, but it was passed through as a long-term capital gain to me on a K-1. I was taxed once! I thought it was the greatest thing ever.
With those prior life experiences, what more did I need to learn? As it turns out – a lot. Tax law is constantly changing, and my new venture was different enough from the scenarios I had seen in the past.
I corrected the horrible branding mistake and rebranded MobileRealtyApps.com as HomeSpotter in 2015. But I could have taken various opportunities to correct my other early mistake and convert the LLC into a C corporation, and I never did.
Here are seven reasons I should have chosen a Delaware C corporation from the start (or converted to one along the way).
First, many seasoned investors will only invest in Delaware C corporations. I wasn’t thinking about raising money in 2010. And there’s a significant reason VCs and angels don’t want to invest in an LLC. C corporations are responsible for their taxes and tax filings. In contrast, LLCs are pass-through entities whose taxes get reported on their collective owner’s taxes.
If you invest in an LLC, you can’t really file your own taxes accurately until you receive a K-1 from the LLC each year so that you know what you have to report on your own return. While that’s unfortunate for angels, most angels already have a complex tax situation and file for an extension each year. It is inconvenient but not a showstopper.
It is utterly disruptive to VCs, however. Each VC fund is responsible for issuing K-1s to each of its many limited partners. VC funds are therefore prevented from distributing their K-1s on a timely basis until they have received all of their portfolio company K-1s (if they have them). As a result, most VC firms refuse to invest in LLCs, as C corporations do not have to issue K-1s.
If you’re lucky, a VC will state on their term sheet that you must convert to a Delaware C corporation before closing their investment. If you’re less fortunate, they won’t take you seriously. It can be such a negative signal that you may not even have the opportunity to discuss their potential investment. They will assume you are not serious about growing a venture-scale business or are getting bad advice.
Second, rewarding your employees with equity is unnecessarily complicated and less advantageous to employees in an LLC. Since LLCs have “units” and not “stock,” things like stock options and restricted stock units aren’t available in the same way they are in a C corporation. We got around this by creating an “equity appreciation rights plan,” which is sometimes referred to as “phantom stock.” I was proud that it had some aspects that were employee friendly, like the fact that employees could keep what they vested if they left and not be forced to pay in and buy stock within 90 days. However, I later learned that our equity appreciation rights plan had disadvantages for the employee and the company. Namely- employees had to be paid their gains via payroll. This meant that both the employees and the company had to pay payroll taxes that wouldn’t have been due if they were capital gains – as they would’ve been with stock options or RSUs. Some of these issues we experienced may have been specific to our plan. Still, generally, there is a more straightforward path with C corporations.
Third, distributing those K-1s each year is unnecessarily painful. It may seem trivial, but the March 15th deadline comes quickly every year. Getting your investors a timely K-1 is more challenging than you might envision. There were often unforeseen complicating factors that delayed the prompt distribution of K-1s. While I was fortunate to have a very understanding set of investors for HomeSpotter, it was never a good feeling having to communicate any reason for a delay.
Preparing and distributing the final year K-1 after the acquisition was particularly onerous. Although we managed to get the K-1s out before the deadline, many investors had questions that needed to be answered due to the nuances of partnership tax law.
Fourth, acquisitions may become unnecessarily complicated with an LLC. In 2019, we acquired a Canadian company, Spacio. The deal we agreed to included a combination of cash upfront, an earn-out, and equity in HomeSpotter. We had to jump through many hoops to effectively issue equity in HomeSpotter to Spacio’s co-founders without creating an undue tax burden on them. This complexity could have been completely avoided if we were a C corporation. Moreover, challenges with reporting across our US and Canadian entities post-transaction led to delays in the timely distribution of K-1s to our investors.
Fifth, and most important to me personally, in an LLC, you lose the opportunity to take advantage of Section 1202 QSBS tax exemptions. QSBS was codified in the tax law in 2010, allowing those holding shares in companies that meet specific criteria to be completely exempt from paying federal capital gains tax (up to specific limits). Many states honor QSBS, and you may be exempt from paying state capital gains as a result. To be eligible for the QSBS exemption:
The company must be a C corporation.
The company must have assets of less than $50 million at the time of the equity issuance and immediately thereafter (including cash received from the issuance).
The company must be a qualified business. Most tech startups should qualify.
The equity must be stock. Convertible notes, warrants, and stock options don’t count.
The equity must be held for at least five years and the business must be an active business for the duration of the investment.
It was painful to write the most significant check of my life to the IRS, knowing that had I done just one thing differently early on, I wouldn’t have had to pay anything. I’m not looking for anyone’s sympathy, as it’s a first-world problem of the best kind. I don’t live with regret, but I occasionally wonder what productive things I could have done with all that additional cash.
This QSBS exemption applies not just to founders but to any investor in the company as well, provided they held for five years. So, collectively, my investors also had big tax bills that could have been avoided with this simple change.
I recommend that anyone who takes a serious look at angel investing become well-versed in QSBS exemptions. I’m told there are additional opportunities to leverage QSBS. Suppose you have a company sell before the five-year holding period, and you take the proper steps. In that case, you can roll the investment into a new one, delay paying capital gains and decrease the holding period required to use QSBS on that next investment.
Sixth, the double taxation of asset sales in C corporations is essentially a thing of the past. Acquirers in many M&A transactions still prefer buying a corporation’s assets instead of all the outstanding stock. The corporation will likely need to pay corporate income tax on the gains. However, the shareholder(s), when they receive the remaining sale proceeds through a liquidating dividend, can use the same Section 1202 cited above to avoid tax on that cash. Also, I’m told that most tech/software acquisitions are stock deals, not asset deals. So, this concern likely won’t apply to you, regardless.
Seventh, incorporating in Delaware could save you numerous headaches and increased legal fees down the road. Having a Minnesota LLC slowed us down and added time (and, therefore, legal fees) during the acquisition because our attorneys had to clarify nuances of Minnesota law with the acquirer’s counsel.
In the context of privately financed companies, Delaware law, in most circumstances, honors the contractual arrangements among stockholders (both founders and investors) as they are written without the threat of a court imposing additional “minority stockholder rights” if someone later decides they don’t like the deal. Under many state corporate statutes, a stockholder can assert these rights arguing they have been unfairly treated or “oppressed” in a broad sense. Such lawsuits (and the threat of them) among founders have destroyed many startups before they even get going. Delaware law limits this risk for everyone. Also, Delaware chancery courts have a broadly understood system for settling corporate conflicts efficiently and don’t allow for jury trials.
Additionally, most priced venture capital financings are done using forms (maintained by the National Venture Capital Association and seriesseed.com) that presume the company is registered in Delaware. While the forms can be adjusted for use with any state, this is an immaterial issue that then needs to be negotiated. The lawyers need to get comfortable with another state’s corporate law, resulting in increased legal costs for the company’s finance work.
Registering in Delaware barely adds additional overhead, so you might as well do it from the start.
So, knowing all of the above, why would a founder choose an LLC or S corporation? If you: a) have a very profitable cash-flowing business or conversely have a business losing money and want to use the losses to offset other personal income, and b) never raise money from VCs, and c) plan to never sell or have a business in an excluded category for QSBS – then an LLC or an S corporation might be the right choice for you. As a business owner, you will avoid double taxation.
But, please heed my warning: if you plan to raise angel or venture capital or sell for a significant outcome, stick to a Delaware C corp. You will be glad you did.
Finally, if you’re a founder about to raise venture capital and have already set up an LLC, don’t fret. This is easily fixable. I recommend proactively converting to a C corporation before talking to VCs. Talk to a good lawyer, and choose one that focuses on tech startups only. If you can’t get this done pre-raise, then at least be proactive in telling investors that you are in the process of converting before closing a round. Whatever you do, don’t say you will convert “if investors require it.” That may signal you’re not serious about raising venture capital or don’t know what you are talking about.
* Someone will inevitably read this, get pedantic, and say that how a company elects to file its taxes and the form and location of incorporation are two totally separate things. (e.g., You could theoretically have a Minnesota LLC file its taxes as a C corporation through a simple IRS election.) Filing to incorporate in Delaware is separate from your filing with the IRS, which designates how you want to be taxed. I nevertheless refer to a Delaware C corporation throughout and recommend you not get cute with this. Register a corporation (not an LLC) in Delaware. Elect to be taxed as a C corporation with the IRS.
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HomeSpotter was a Minnesota LLC, and I highlighted several reasons I should have formed a Delaware C corp.
Some companies (lifestyle, strong cash flow, non-qualified businesses) avoid double taxation for their owners by choosing to be an LLC or S corp.
However, HomeSpotter’s LLC structure created operational challenges along the way and resulted in paying higher taxes when we sold.
Founders and investors can minimize federal capital gains taxes when selling through QSBS. To take advantage, the company must be a C corp., the stock must be held for at least five years, and a few more critical conditions must be met.
Nearly every venture-backed business is a C corp. Raising venture? Stick to a C corp. from the start.
Form that corporation in Delaware to avoid unnecessary challenges down the road.
If you formed an LLC and are about to raise a venture round, don’t fret. This is fixable.
Seek a competent startup attorney and CPA, and don’t take my advice alone.
Special thanks to HomeSpotter’s M&A counsel, Chris Carlisle, and HomeSpotter investors Daren Cotter, Casey Allen, Scott Burns, and Rob Weber for reviewing an early draft of this post and providing feedback.